Description

Some of the things I look for in a long investment include a big change event (and/or uneconomic sellers), an entrenched business, excellent CEO, strong balance sheet with excess assets, and big valuation upside.   Royal Mail Group hits every one of these elements. 

An additional interesting aspect of the setup here has to do with the IPO process.  By all accounts the company, gov’t and underwriters rushed this to market with almost no price sensitivity as they wanted to get it public before the unions could stop it.  This was a large element in a highly mispriced IPO.   On the other side of that there has been public and political backlash, including hearings, finger pointing, etc.   The net of all this has been the creation of a CYA dynamic whereby the underwriters are all putting out research notes talking down the stock, using overly bearish projections, misleading comp valuations, etc.  

RMG is a recent IPO/privatization of the UK gov’t.   The company currently trades at sub 10x EV/2014 FCF, with FCF growing substantially over the next few years as margins expand (outlined in detail below).  While I would argue RMG is better positioned than most of their comps due to the growth profile of their parcel business, using comp valuation metrics we get to upside of 30-40% over the next year (~£7.50 - £8.00/share). 

I also believe there is additional upside with ~£500 MM in excess central London real estate currently identified on the balance sheet that is being developed for luxury apartment sales and the potential sale of GLS.  All in, I believe the incremental upside could be another £1.30/sh, incremental upside of ~25%.  While I don’t have specific insight as to if GLS could be sold (there are not any meaningful synergies with their core UK parcel business), TCI recently filed owning over 5%, so it’s possible they push the company to spin GLS, and/or get more aggressive with their excess real estate sales.   To be clear, this is not a key to the thesis, but just additional upside optionality. 

RMG is the privatized U.K. postal service, which has a dominant position in domestic mail and deferred parcel deliveries market combined with a domestic express parcel business (called Parcelforce).  The company also has a leading Western European deferred parcel delivery service (Germany, Italy, France primarily), named GLS.  Within the UK business, letter volumes are declining MSD, but this is largely offset by pricing growth following the 2011 deregulation, and the parcel delivery business is organically growing at HSD/LDD rates from the secular growth in UK based ecommerce, where RMG has a dominant market share of ~36% (vs. 7% for the closest competitor).  With increasing productivity gains to come from the ongoing technology and infrastructure transformation along with a well-protected business in the UK, earnings and free cash flow power should grow significantly over the next 3-5 years. 

What the Privatization Has Changed: 

Shedding of Pension and Post Office Network – As part of the privatization, RMG separated from its primary pension and retail post office branch network, where a significant portion of the fixed costs and personnel are.  The pension removal enhanced the B/S and cash flow while the PO separation removed a substantial portion of the operating leverage via the fixed cost base and relatively low incremental revenue associated with the PO branches.  RMG retained an exclusive agreement to service / use the PO network for the next 10 years where the POs collect stamp and other revenue on behalf of RMG who in turn remunerates some of that revenue to the POs along with a periodic fee.  The POs are also a major competitive advantage for parcel drop-offs.

Technology / Automation – RMG has spent £2.8 BN between 2006 and 2012 to modernize the dated distribution network, namely by adding automated letter sorting and other essential IT functions, to create operating efficiencies.  The letter business automation is now complete (RMG added 995 new letter sorting machines whereby in FY13 95% of letters were machine sorted and 79% were automatically sequenced for delivery vs. 8% for both factors in FY10).  The ongoing investment is in the automation of the parcel business, namely in automated sorting / IT for parcels.  So far, RMG has introduced handheld scanners (50K to date / 73K by end of 2013) and is in the process of implementing automated parcel sorters.  In addition to the automation / IT upgrade, 28 mail centers have been closed, with 5 more scheduled for closing in FY13 along with 4 new/refurbished ones set to open.  The company expects 2% to 3% future annual productivity gains from these investments – importantly, these are not just pie in the sky projections, the primary driver in productivity improvements is an agreement the company has with its unions to reduce the size of their workforce each year by the number of retirees (i.e., don’t hire new people to replace those retiring).  As you can imagine with a legacy post office system, there are tremendous opportunities for improved productivity. 

The company is also in the midst of a £160 MM investment plan (£35 MM invested in FY13) for Parcelforce, the UK express parcel business, adding a new processing center in Chorley (opened September 2013) along with 10 new / refurbished depots to increase express capacity within the U.K. by 1/3 to 93 MM parcels/year.  The investment also adds barcoding and tracking technologies as well as small package automated sorting machines and the related IT equipment / software.

Regulation – Starting 3-27-12, Ofcom’s mandate changed such that its primary fiduciary is now to ensure an adequate rate of return for the Royal Mail system (this is a subtle but incredibly important point).  That rate of return is estimated at EBIT margins of 5% to 10%.  Second, stamp pricing was deregulated in 2011 with the establishment of this Ofcom mandate.  Now pricing has been opened to the Royal Mail but only to the extent Ofcom signs off, which it did for the recent 39% stamp price increase in 2011 - note that was a retroactive "makeup" for the 7 prior years of zero price increases.  Future pricing is expected to be more moderate in the LSD to MSD range.

The CEO – Moya Greene became the CEO in May 2010 to privatize Royal Mail.  She is a restructuring person with specialization in public-to-private infrastructure assets, having worked on both the public and private sector side of the equation.  Our checks on Moya have painted a consistent picture of this being her skill set, particularly with labor relations, along with tier one work ethic and abilities.  She was the Assistant Deputy Minister for Transport in Canada and responsible the privatization of Canadian National Railway and the deregulation of the Canadian airline industry.  In 1996 she was MD of Infrastructure Finance at TD Securities and in 2000, she became Chief Administrative Officer of Retail Products at CIBC.  In 2003 she became SVP, Operational Effectiveness at Bombardier; she resigned in 2004 following the CEO’s departure and the successful restructuring of the European rail car business.  After that she became CEO of Canada Post in May 2005, during which she focused on cost cutting through lower absenteeism, increased automation and improved labor relations.  She’s also on the board of THI.

Risks 

VAT review – PostNL offers letter delivery in the UK, primarily in the high-density London area.  Royal Mail benefits from a VAT exemption that enables pricing ~20% below any competitors, which are primarily PostNL/TNT and UK Mail.  On the flipside, RMG is obligated to provide USO (universal delivery across the country/region), including the unprofitable, low density areas in the countryside and cannot "cherry pick" high density MSAs such as London.  Because PostNL is just now reaching break-even profitability and at a disadvantage, it has requested a judicial review of the VAT exemption for Royal Mail.  The judge decides whether to make a decision or pass along to the EU courts.  It is a risk, but its merit is precarious - it's hard to see how PostNL has a logical argument with Royal Mail obliged to provide USO coverage.  Competitors across Europe have attempted to compete in the letter business against privatized national postal systems and failed repeatedly with one exception in the Netherlands where PostNL has lost considerable share from a competitor who required 10 years to become profitable (just now) in a market where competition was encouraged.  Unlike the EU, in the UK, Ofcom's goal is to protect the postal system, not the consumer.

Potential for strikes – the labor unions were set to strike Nov. 4^th but called it off as a new labor deal had been reached between the unions and Greene following the strike ballot but before the actual strike occurred.  This strike was planned before the privatization, and the unions are upset with the government, not Royal Mail and its shareholders.  Shortly before the IPO but after the planned strike, the unions negotiated an 8%+ pay raise over 3 years, which is quite satisfactory to the unions, and each union member now holds ~£5K of stock (locked for the next 3 years), but future strikes are always a risk even if muted for the medium term.

Letter volumes – Letter volumes are forecast to continue declining 5% to 6% per year, and RMG must initiate price increases to maintain profitability in that business, which may not be easy to pass through.  Furthermore, mail volumes could decline at even greater rates going forward if technology adoption accelerates.  Fortunately letter pricing was deregulated in 2011, at which point RMG initiated a 30% stamp price increase (over 2 years) with more signaled for the future.

 Earnings Power & Projections

RMG is cheap on a current levered FCF basis of 10% excluding transformation expenditures, and FCF should grow meaningfully as the transformation efforts (namely IT infrastructure build and the related labor efficiencies) play out while the business mix shifts towards parcels.  RMG’s overall sales should grow 3% to 4% per year and margins should grow significantly from the continued IT and distribution system investment, such that LFCF grows from ~£300 MM in 2013 to ~£800 MM in 2016.  The two big FCF growth drivers are 1) personnel cost leverage from the IT transformation / upgrade and negotiated voluntary FTE retirements, and 2) the transformational operating expenses and capex coming off over the next 3-5 years. 

 Revenue Drivers:  Volume and pricing growth for each of RMG’s 3 businesses, UK parcels (UKPIL segment), UK mail (UKPIL segment) and European parcels (GLS segment), result in annual sales growth of 3% to 4%.  Assumptions by market segment are:

 1. UK Parcels:  4% volume growth (2% in FY13 from size-based parcel pricing transition) / 5% pricing growth.

 2. UK Mail:  6% volume declines / 5%-6% pricing growth (vs. 7% to 11% in FY11 and FY12).  For what it’s worth, the company says they could see the rate of declines starting to slow at some point as everything that can switch to electronic, does – for my projections  I am leaving mail at a flat -6%. 

 3. European Parcels (GLS business):  2% volume growth / 0% pricing growth.

Operating Expenses:  Given the heavily fixed cost nature of the business and continued leverage of the IT spend and distribution system upgrades / rationalization, my projections assume for the UK business that personnel expenses account for two things negotiated in the most recent labor deal: 1) the 2.2% annual wage increase over the next three years, and 2) the 3K annual FTEs who will enter voluntary retirement over the same period.  All other UK business operating expenses assume minimal leverage in the range of 0 to 50 bps over the next 4 years for each line item.  For the GLS business, I assume no operating expense leverage / margin growth.

Competitive Landscape / Comps:  The 3 most comparable business models for RMG LN are the other publicly traded European national postal systems that have been privatized, including Bpost (BPOST BB), Austria Post (POST AV)  and PostNL (PNL NA, fka TNT).  Bpost is the closest comp as it's a pure play national postal system that delivers letters and parcels domestically, while Austria Post has a greater international presence, primarily in deferred parcel delivery.  PostNL has a 30% stake in TNT Express and an international letter business, which has entered the UK. Outside of PostNL, none of these peers compete in the UK domestic mail and parcel delivery business.

In terms of the UK market, Royal Mail delivers ~99% of letters and 36% of parcels (32% through Royal Mail and 4% through the domestic express business, Parcelforce).  PostNL has attempted to compete in select high density markets in mail but has remained unprofitable/break-even from the pricing disadvantage (its mail is not VAT exempt).  Other competitors have attempted to enter the domestic UK mail / parcel business and exited from the inability to compete profitably, such as DHL.  

The parcel market is more competitive than letters given its secular volume and pricing growth, driven by the development of the domestic ecommerce market.  Volumes and pricing are each growing MSD in the UK parcel market.  RMG has maintained dominant share of 36% with its infrastructure from the Royal Mail postal system along with the addition of domestic express delivery in Parcelforce, which gives RMG the ability to deliver anywhere in the country at any time with an infrastructure that is very difficult to compete with.  The next closest competitor has 7% share (Yodel) and a handful of others have 5%-6% (TNT, DPD, UPS, Hermes and City Link) with the remaining 30% fragmented among other smaller providers.

Mail & Parcels:  For the UK mail and parcels businesses, Deutsche Post / DHL (Germany), Bpost (Belgium) and PostNL (Netherlands) are the most comparable business models as the national postal systems in their respective countries.  In comparing the respective markets, the Netherlands letter volume decline is in the HSD/LDD range while the UK and Belgium are declining MSD; the Netherlands is further behind in the adoption of electronic substitution so the rate of decline is accelerating relative to the other countries.  The cumulative decline in volumes for the Netherlands was 22% between 2007 and 2012, while it was 26% for the UK (and US).  In 2012, PostNL’s letter volumes declined 9%, whereas RMG’s declined 6%.  The parcels business is the growth driver for these businesses that offsets the letter volume declines.

Another structural difference for the Netherlands / Belgium / Germany (the EU) vs. the UK mail business is that the UK business has the support of the Ofcom regulators to preserve the Royal Mail system, whereas in the EU countries faced the opposite where its postal markets were deregulated in 2006 and competition was encouraged with the primary goal to protect the consumer, not the post office.  Royal Mail is also the only postal system with deregulated pricing, which is a key profitability differentiator.

Margins:  I assume EBITDA margins excluding transformational costs grow from 9.6% in 2012 to 15.4% in 2016 from the personnel expense leverage of 500 bps over that time.  As a template, Bpost transformed / restructured its business before going public earlier this year, and EBITDA margins increased by a similar amount of 450 to 500 bps from 2008 to 2012.  Today Bpost has EBITDA margins of 20% whereas by 2016, I project EBITDA margins before transformation costs of 16% (15% after transformation costs), which seems quite reasonable.  Note that RMG LN, unlike BPOST, has deregulated pricing and can maintain or grow margin with greater flexibility.  The one offset to that superior pricing discretion may be a less flexible union.

Valuation:  Unlike PostNL or Bpost, RMG is a transformation / earnings growth story today.  These companies are often valued on forward EBITDA, where the peer group trades for ~6x forward EBITDA. Valuation will depend on whether the investment community decides to count transformation costs in its financials and valuation analysis.  In one year, if the market includes the transformation costs, the stock would be worth ~£7.50/share at 6x EBITDA, upside of 30%+.  If the market excludes transformation costs, the PT is £8.00/share, upside of 40%.

As the transformation is completed, RMG will eventually pay a dividend and as such may become valued towards yield, where the peers trade for a 6% to 7% yield, but there is significant earnings growth to achieve before that happens.

FCF:  This depends a lot on how the transformational capex comes off over the next 3-5 years.  In FY13, I project total capex of £415 MM, of which £220 MM is classified as recurring capex, which results in levered free cash flow (LFCF) of ~£275 MM when incorporating total capex and transformational expenditures.  If you exclude transformational capex and operating expenses, LFCF is ~£550 MM.  The majority of the transformational capex and operating expenses run off over the next 3 years, such that LFCF grows to ~£810 MM including transformational expenditures and ~ £935 MM excluding them.  The two key drivers of this LFCF growth are: 1) personnel expense leverage from voluntary retirement such that UK personnel expenses decline from 59.0% of sales in CY2012 to 54.5% in CY2016, and; 2) transformational operating expenses and capital expenditures declining from £372 MM in CY2012 to £150 MM in CY2016.

Bpost, the most comparable in terms of a pure-play domestic postal system, spends 2.5% to 3.5% of sales on capex; my assumptions have total capex going from 4.5% of sales in CY2013 to 3.5% in CY2016.

The financial projections are below:

Business & Market Overviews

Business Overview:  RMG has two segments – (1) UKPIL and (2) GLS.  UKPIL can be divided between the UK letter delivery business and UK parcel delivery business and within it are two entities: Royal Mail (letters and deferred parcels) and Parcelforce (express parcels only).  Royal Mail is the legacy Royal Mail business, or the traditional UK postal service, which delivers both letters and parcels on a “deferred” basis, i.e., multiple business days, generally up to 3.  Parcelforce is the express parcel business within the U.K. operating on a hub-spoke system with its hub at Heathrow.  The business operates separately from Royal Mail and the two entities do not share logistics infrastructure.  GLS is a leading deferred parcel business in Europe with 70% of revenue coming from Italy, Germany and France; it currently has superior margins to the UK business and is a pure play parcel business that does nothing but ground transportation of deferred parcels within Western Europe.

U.K. Parcel Business (32% Sales / $2.9 BN)

This is the growth driver for the UKPIL business.  RMG is the leading parcel shipper in the UK, with ~31% market share from Royal Mail + 5% share from Parcel Force, for a combined 36% share, with the next closest competitor, Yodel, having 8%.  The infrastructure and the brand are meaningful barriers and cost advantages that provide a solid moat for this business.  Market share is: RMG 37%, Yodel 8%, TNT 7%, DPD 5%, UPS 5%, Hermes 5%, City Link 4% with the remaining 30% divided amongst other smaller players.  RMG has the leading infrastructure to scale and compete on pricing and parcel drop-off locations with the ability to capture a meaningful portion of the 30% of fragmented market share.  As evidence, RMG grew parcel share in FY13 by ~200 bps from 34% to 36%.

Customer Segments:  The market breaks down into 3 customer segments – B2B, B2C, and C2X.

B2B (38% of total market):  Packages sent amongst businesses.

·         Historical Market Growth: 3%/yr from 2009 to 2012.

·         Projected Market Growth:  “just above UK GDP” [2% to 3%]/yr from 2013 to 2016.

B2C (56% of total market):  Packages sent from businesses to/from consumers.

·         Historical Market Growth:  5.2%/yr from 2009 to 2012.

·         Projected Market Growth:  5% to 6%/yr from 2013 to 2016.

C2x (6% of total market):  Packages sent to one another and non-return packages to business.  Return packages to businesses are in B2C.

·         Historical Market Growth:  5.2%/yr from 2009 to 2012.

·         Projected Market Growth:  4.5% to 5.5%/yr from 2013 to 2016.

Market Volume Growth:  The growth driver for the industry is the B2C business, driven by online retailing / ecommerce, which is magnified by the corresponding product returns.  Therefore, the growth in online retailing (particularly apparel, shoes, etc.) has multiplicative impact on parcel delivery growth.  In addition, over recent years, retailers have increasingly offered “click and collect” services for consumers to collect parcels from a designated collection point if delivery to a home address fails – this location can be a delivery point offered by the parcel carrier or in a retailer’s store.

Click-and-Collect:  In May 2013, Royal Mail launched an effort in conjunction with the Post Office to launch the UK’s largest “click and collect” network which will give online retailers the option to have parcels delivered using the Royal Mail Core Network to its 10,500 participating PO branches for customer pickups.  This is as much of a defensive move as an offensive move; it blocks competitors, who are also building click-and-collect locations, from closing the convenience gap with Royal Mail and its PO network for drop-offs.

Delivery Time Segments:  The market also breaks down into 3 timing segments – Deferred, Express and Courier.

Deferred:  This is the least time sensitive deliveries on “second class” schedule – generally 3 working days.  In the U.K., these parcels go through Royal Mail, not Parcel Force.  The top competitors are Hermes and Yodel which operate low-cost models.

Express:  This is the intermediate time sensitive deliveries, on a defined day basis as short as next day delivery.  In the U.K., these parcels go through Royal Mail and Parcel Force.  The top competitors are DPD and City Link.

Courier:  This is the most time sensitive deliveries, often same day or even a number of hours.  This is an insignificant piece of RMG’s business which goes through the Royal Mail business, and competition is very fragmented with only one leading player, CitySprint. 

U.K. Letter Business (52% Sales / $4.8 BN)

This is the declining volumes component of the U.K. business which RMG mitigates with pricing growth.  U.K. letters comprise 52% of total RMG revenue (FY13). The business has 3 markets: end-to-end, network access, and international letters.

End-to-end:  There is almost no competition here with the exception of a small amount of competition from TNT and Document Exchange.  RMG handles almost 1 MM items per week (end-to-end).

Network Access:  RMG has “upstream” mail competitors who use the Royal Mail network for the “last mile” of delivery via its mailmen.  7.3 BN of RMG’s letters (42% of total letters delivered) came via Network Access in FY13 – it’s predominantly business mail (bills, etc.) and marketing materials.

International Letters:  RMG exported 300 MM letters / imported 400 MM for international delivery.  There is competition in this market from An Post (Air Business subsidiary) and a La Poste / Swiss Post JV (Ascendia).

Market Volume Growth:  From 2007 to 2011, letter volumes declined 26%.  In 2012, volumes declined 8%.  Forecasts are for declines of 4% to 6% between 2013 and 2016.  The obvious driver is the electronic substitution of snail mail via email, and internet advertising / communications.

Market Pricing Growth:  Royal Mail increased stamp prices by almost 40% in 2011 to 55 pence (second class) – the U.K. Ofcom has to deem the pricing as “affordable” for pricing to be passed through – it’s not 100% discretionary; RGM sets the price but Ofcom approves it.  With that, Ofcom has cited the “severe risk” to the postal service if price increases are not approved.  RGM’s CEO and its prospectus cite the potential for more pricing growth using other European countries as comps including Germany (57 pence/stamp), Italy (87 pence/stamp) and the European average (57 pence/stamp).  

European Deferred Parcel Business / GLS (16% Sales / $1.5 BN)

This is the GLS business, which is the European cross-border deferred parcel business where delivery timing is generally multiple days.  GLS also has very small courier business (single item, fast route, generally within a day) and express parcel business (next day or sooner).  Approximately 73% of volumes at GLS were B2B with 27% in the B2C category.

Competitive Landscape:  GLS is one of the largest ground based deferred parcel players in Europe. 71% of sales are from Germany, France and Italy combined.

RMG uses just ground transportation for the European parcel business, whereas the competition is largely the integrated and express carriers as well as courier services and.  The integrated carries own / lease air cargo fleet and target large, multinational customers, not just those who operate within Western Europe.

German competitors = DHL, DPD and UPS.

French competitors = La Poste and TNT.

Italian competitors = Bartolini, TNT, Poste Italiane and DHL.

Market Volume Growth:  In 2012, European deferred parcel volumes declined from the macroeconomic environment, and the GLS business declined 4% that year.  GLS has been growing above GDP by expanding into new geographies as parcel volumes are projected to grow throughout Europe, also driven by the growth in online retailing and the related customer returns.  GLS is currently focused on expanding into Eastern / Central Europe.

Summary

Recent highly mispriced IPO still has 30-40% upside to get to comp valuations, even though the business is better positioned than comps (particularly how dominant they are in UK parcel, and their regulators mandate to ensure the mail business remains profitable).  There is also an additional 25% upside in excess/non-core assets, and a potential activist had purchased over 5% of the company.

DISCLAIMER: The views expressed here are merely the opinion of the author. Please do your own research.  I may change my position at any time without posting an update.

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